GSEs embrace option ARMs and I/Os

Agency ARM issuance surged in September, jumping to $23.8 billion in September from $14.3 billion in August - the highest monthly issuance level ever recorded, according to Merrill Lynch analysts. Much of the growth could be attributed to Fannie Mae and Freddie Mac slowly embracing affor-dability mortgages in the ARM sector. After having shied away from option ARMs, for instance, the GSEs are starting to warm up to these products as evidenced by purchases over the last two months.

Morgan Stanley analysts reported that gross agency hybrid issuance more than doubled between August and September, largely driven by option ARMs. For instance, Fannie Mae securitized roughly $8.5 billion of option ARMs in September, comprising 43% of its gross issuance for the month.

The option ARMs securitized by Fannie consisted of seasoned collateral so the jump in issuance does not suggest any structural shifts in origination trends, according to Morgan Stanley. Over August and September - across Fannie and Freddie Mac - there was also a 30% to 50% rise in typical hybrid reset gross issuance, mostly in 5/1s. In terms of fixed rate product, gross issuance went up by 13% over the same time frame, which could be attributed to the GSEs' securitizing more ARMs "in an effort to gain on the non-agency market (where majority of ARMs and hybrids are securitized)," researchers stated.

"So far, agency participation in the hybrid market had been limited as the agencies shied away from I/Os and options ARMs, the two main growth areas in the non-agency market," noted Morgan Stanley analysts, adding that this has consequently played a role in the significant rise in Alt-A MBS production.

Although Jumbos traditionally made up most of prime non-agency issuance, the Alt-A share in the sector has been increasing over time and has topped 50% in the first half of this year. But to the extent that the GSEs make an effort to alter non-agency dominance in the ARM sector, this will result in an increase in agency ARM production even if overall ARM origination stays flat or even declines.

"Indeed, the agencies have started to play a greater role within I/Os since the start of 2005, and should now benefit from this increased thrust on the hybrid market," analysts noted, adding that with I/Os currently making up roughly 70% to 80% of jumbo and Alt-A securitizations - which should reflect origination trends - the agencies would be "missing a big chunk of the market" if they do not increase their presence in the I/O sector.

In terms of relative value, although ARMs (non-option) origination is expected to decrease versus fixed rate mortgages, the GSEs continuing to grow and securitize ARM production would pressure the agency hybrid basis. The non-agency hybrid basis should also tighten, specifically in Alt-As. Morgan Stanley analysts also note that although agency securities do not have any credit risk, since most of these option ARMs are structured as passthroughs, investors remain exposed to the Libor to MTA

basis risk.

In a separate report, Morgan Stanley analysts noted that hybrid volume expected to reset and be capped should be significant versus the current size of the short agency ARM market. Even though investors will likely keep the seasoned hybrids due to reset, it should not negatively impact short ARMs. Selling pressure should be limited due to near-term growth in agency short ARM production, among other factors.

In terms of prepayments, Merrill Lynch analysts said that September's jump in agency ARM issuance could possibly result in slightly higher prepayment dollar volume as these loans season. The robust pace is not expected to continue, added Merrill analysts.